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Using Exchange Traded Derivative Products to Protect against Volatile Bullion Prices

Shivanshu Mehta, Head – Bullion, MCX

 

Precious metals like Gold and Silver are vital components of jewellery manufacturing. But the volatility in base prices of these metals has the potential to adversely impact the fabrication margins for the jewellery industry. With an aim to secure and hedge narrow profit margins and insure oneself from losses as precious metal prices oscillate, jewellers can utilize hedging via different combinations of products like Futures and Options on Commodity Derivatives Exchanges.

 

MCX has played a major role in strengthening of the financial markets by enabling hedging of commodity price risk through commodity derivatives. It has integrated rural, urban and global markets, facilitated efficient price discovery, increased awareness about quality standards, instilled price transparency besides providing convenience & assurance of delivery. Over the years, MCX price in many commodities has emerged as the benchmark for participants across the value-chain of those commodities. For instance, pricing in gold and jewellery markets are done on MCX (+/-) basis in several locations, that is, using MCX gold prices as the acknowledged reference price. Participants across the bullion value chain also find MCX a preferred platform for hedging their risks arising from volatility in bullion prices.

 

As MCX gold prices reflect the international gold price, USD-INR rate, import duty changes, and prevailing premium/discount, MCX prices are a natural hedge against these movements. This enables all major value-chain participants such as importers, exporters, nominated agencies, bullion traders and branded and retail jewellers to hedge their price risk efficiently. MCX gold prices have a strong correlation with international benchmarks (e.g. 98.93% with the INR equivalent import parity price of CME gold) as well as with domestic physical market (e.g. 98.02% with Ahmedabad market spot prices).

 

One primary uncertainty that jewellers need to tackle is the above mentioned volatility in prices. If we were to multiply India’s total gold and silver imports in CY 2017 with their respective annualized volatility percentage of about 9% and 14%, we get respective values of around Rs. 19,000 crores and Rs.2,800 crores, which indicate the quantum of risk the industry is exposed to annually. This is where MCX contributes as an ideal risk management platform for the value chain participants of the industry.

 

Thus, physical participants, such as jewellers, are able to lock in their input prices or hedge their inventories using MCX gold derivatives. For instance, when a jeweller buys gold at a price, he faces the risk of price fall by the time he sells the jewellery, to hedge against which he could short MCX Gold futures.

 

As for sourcing of raw materials, the delivery mechanism at MCX ensures the quality and quantity of supply of the commodity to all stakeholders. More than 100 tonnes of Gold & over 2808 tonnes of silver have been delivered using the MCX platform since its inception in 2003, demonstrating the acceptance of MCX platform by physical market stakeholders.

 

India’s jewellery industry is at a transformational stage. Traditional and largely unorganised jewellery businesses are slowly making way for corporate players. Policy reforms such as demonetisation and GST and related compliances have only accentuated this shift. Smaller jewellers are feeling most threatened with the transformation as they are devoid of better margins and connectivity to the larger world of financing.

 

At the same time, jewellers are also feeling the heat of large volatility in gold prices. During CY2017, annualised price volatility in gold had been over 14%. This means that a jewellery firm with a gold stock of Rs. 100 crores is exposed to a price risk of Rs. 14crores, enough to put its business planning process in jeopardy. While small jewellers look towards various effective hedging options available, some big jewellers take to metal loans to hedge the risks arising from gold price uncertainty, but only with partial effect.

 

It is in this market scenario that MCX decided to offer a product that would meet the risk management needs of even the small jeweller, beyond what was available to them by way of the multiple-sized gold futures contracts. SEBI permitted Exchanges to apply for commodity options in 2017 and MCX has launched gold options with gold 1 kg futures as the underlying. This has been one of the most significant recent developments. By becoming India’s first commodity exchange to offer commodity options, MCX has been a pioneer in reaching out to the hedgers at large.

 

Options is an interesting hedging product for jewellers as they are able to participate on the favourable side of the price movement and yet remain insured against adverse price movements. The maximum loss is a pre-decided number of 1-2% of contract value, which is the extent of Premium paid by an option buyer to seller. One can try a combination of futures and options that gives the advantage of futures trading and the security against loss while trading with options. The one-time payment and taxation on premium go easy on your expenses. The options on expiry on exercise devolve into the underlying futures contract. A wide array of effective hedging strategies can be created using combinations of futures and options.  These combinations can give the hedger the leverage of futures with safety of options, a strategic benefit not available earlier. Above all, thanks to their low transaction cost and high hedging effectiveness, options provide better cash-flow management to hedgers.

 

Some of the hedging practices used by the Gold miners are of creating a floor price by above the money calls and protective puts below the money. Jewellers can create flexible pricing schemes for their walk-in customers, by buying Puts at current prices and offering the choice between the prices of either that day OR of a festive date whichever is lower. For inventory price protection, some jewellers write calls above the money when implied volatility of the metal is higher, thereby can reduce cost of carry.

 

MCX has continuously engaged with physical industry for creating awareness among value chain participants on options, having conducted 101 seminars with bullion & jewellery associations covering more than 16000 entities from physical industry held in FY 17-18.

 

After the launch of liquidity enhancement scheme (LES) at MCX on 24th April 2017, the liquidity in the Gold options has gained significantly and hedgers can now take this opportunity to actively participate in the Gold options for their hedging needs with lesser impact costs.

 

The Gold Options Contract has shown significant traction post the implementation of LES which is evident in the table below:

 

It is pertinent to note that amendments in Section 43(5) of the Income Tax Act, 1961, now ensure that hedgers no longer need to show physical delivery of commodities to prove that their transactions are in the nature of hedging and not speculation provided they are on Regulated Stock Exchanges. Such income or loss is off-settable against business income.

 

Commodity price risk forms a major risk to corporate. Signifying the same, SEBI Listing Obligations and Disclosure Requirements (LODR) Regulations 2015 made all listed companies to disclose their commodity price risk and hedging activity in their Annual Reports.

 

Disclaimer: Views are personal and not the views of the publisher.